3 Easy Analogies To Understand The Stock Market

The word “analogy” is defined by the Cambridge Dictionary as a “comparison between things that have similar features, often used to help explain a principle or idea.” It is a useful way for us to understand a topic that’s complicated or new to us.

One topic that is often made overly complex is investing in stocks. Fortunately, I have three analogies – sourced from greater minds – that can help us cut through the fluff and get to the point about the core of stock market investing.

Watching the right thing

The first analogy is from Ralph Wagner, who ran the US-based Acorn Fund from 1970 to 2003. During his tenure, he led Acorn Fund to an impressive annual gain of 16.3%. This is also significantly better compared to the S&P 500’s return of 12.1% per year over the same period. 

Wagner once said: 

“There’s an excitable dog on a very long leash in New York City, darting randomly in every direction. The dog’s owner is walking from Columbus Circle, through Central Park, to the Metropolitan Museum. At any one moment, there is no predicting which way the pooch will lurch.

But in the long run, you know he’s heading northeast at an average speed of three miles per hour. What is astonishing is that almost all of the dog watchers, big and small, seem to have their eye on the dog, and not the owner.”  

In Wagner’s terminology, the stock price is the pooch, while the underlying business of the stock is the owner. Instead of watching the dog (the stock price), we should be focusing on the owner (the business).

My favourite example of this is Warren Buffett’s investment conglomerate, Berkshire Hathaway. The chart below shows the percentage change in Berkshire’s book value per share and its share price for each year from 1965 to 2018. There were years when the two percentages match closely, but there were also times when they diverged wildly. A case of the latter is 1974, when Berkshire’s book value per share grew by 5.5% even though its share price fell sharply by 48.7%.

In all, Berkshire’s book value per share increased by 18.7% per year from 1965 to 2018. Meanwhile, its share price was up by 20.5% annually over the same period. An input of 18.7% had led to a similar output of 20.5% over the long run despite wide differences at times during shorter timeframes. 

Predictions are hard

Dean Wlliams is the owner of the second analogy. There are only two things I know about Williams. I couldn’t find anything else about him online – if you know more about him, please reach out to me! First, he’s an investor who was part of Batterymarch Financial Management. Second, he wrote one of the best investment speeches I’ve ever come across. The speech, delivered in 1981, is titled Trying Too Hard.

Here’s the analogy:

“The foundation of Newtonian physics was that physical events are governed by physical laws. Laws that we could understand rationally. And if we learned enough about those laws, we could extend our knowledge and influence over our environment.

That was also the foundation of most of the security analysis, technical analysis, economic theory and forecasting methods you and I learned about when we first began in this business. There were rational and predictable economic forces. And if we just tried hard enough… Earnings and prices and interest rates should all behave in rational and predictable ways. If we just tried hard enough.

In the last fifty years a new physics came along. Quantum, or subatomic physics. The clues it left along its trail frustrated the best scientific minds in the world. Evidence began to mount that our knowledge of what governed events on the subatomic level wasn’t nearly what we thought it would be. Those events just didn’t seem subject to rational behavior or prediction. Soon it wasn’t clear whether it was even possible to observe and measure subatomic events, or whether the observing and measuring were, themselves, changing or even causing those events.

What I have to tell you tonight is that the investment world I think I know anything about is a lot more like quantum physics than it is like Newtonian physics. There is just too much evidence that our knowledge of what governs financial and economic events isn’t nearly what we thought it would be.”

Newtonian physics – the laws of nature governing our daily life – is neat and tidy. You can calculate gravity, air resistance, motion etc. with precision. This is how NASA managed to calculate precisely how long it would take for a spacecraft to travel from Earth to Pluto. In January 2006, NASA launched the New Horizons spacecraft, which reached Pluto in July 2015. The five billion kilometre journey “took about one minute less than predicted when the craft was launched,” according to NASA.

Quantum physics – the laws of nature governing atomic or subatomic particles – is far messier. When I first learnt about quantum physics in school, I was fascinated by the idea that it is impossible to simultaneously measure a particle’s position and velocity. In fact, the act of measuring a particle itself can change the thing you’re trying to probe.

What Williams is trying to bring across in his analogy is that investing is messy, just like quantum physics. Investing does not lend itself easily to tidy predictions, such as those common in Newtonian physics. This is shown clearly in the tweet below by investor Ben Carlson.

The case for long-term thinking

The third analogy comes from Jeremy Grantham, the co-founder and investment strategist of the asset management firm GMO. At the end of 2014, GMO managed US$116 billion in assets.

Financial journalist Maggie Mahar shared the following quote from Grantham in her excellent book Bull: A History of the Boom and Bust, 1998-2004:

“Think of yourself standing on the corner of a high building in a hurricane with a bag of feathers. Throw the feathers in the air. You don’t know much about those feathers. You don’t know how high they will go. You don’t know how far they will go. Above all, you don’t know how long they will stay up…

…Yet you know one thing with absolute certainty: eventually on some unknown flight path, at an unknown time, at an unknown location, the feathers will hit the ground, absolutely guaranteed. There are situations where you absolutely know the outcome of a long-term interval, though you absolutely cannot know the short-term time periods in between. That is almost perfectly analogous to the stock market.”

Making sense of short-term events in the stock market is practically impossible – just like how it’s impossible to tell how a feather will travel when it’s in the air. But over the long run, it’s easier to make sense of what’s going on in the stock market. Over time, richly valued stocks and stocks with poor business results tend to come down to earth, while stocks with underlying businesses that do well tend to rise significantly. This is similar to how a feather will hit the ground eventually.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.